Encounter

Editor's note: In today's part 2 of our coverage of Morningstar's Canadian equity roundtable, the portfolio managers weigh in on the energy sector. They discuss the importance to the industry of a favourable decision on the Trans Mountain pipeline project, and the potential impact of carbon taxation.

About the Author

Sonita Horvitch is a Morningstar columnist who specializes in reporting on money managers and their strategies. A veteran financial journalist, she was formerly with the National Post and its predecessor, the Financial Post. At the Post she was best known as the author of the popular Buy & Sell column, which she wrote from its inception in 1994 to December 2008. She holds a master's degree in business economics from the University of the Witwatersrand in Johannesburg, South Africa.

Michael O'Brien, managing director and head of the core Canadian equity team at TD Asset Management Inc. His mandates include that of lead manager of TD Canadian Equity and TD Balanced Income.
Morningstar columnist Sonita Horvitch convened and moderated the roundtable. Her three-part series began on Monday and concludes on Friday.

Q: Energy is so important to the Canadian economy and to the Canadian equity market. What is the outlook for energy stocks?

Michael O'Brien

Michael O'Brien: In 2016, the oil market was able to absorb Iran coming back into the market. Inventories seem to be capping out here, even declining. The global oil market is closer to being balanced. Given the ability of U.S. shale producers to bring oil to market quickly, the question is: How high can the oil price go up in the near term? This is the big unknown. By contrast, you have the Canadian oil-sands projects, which are long term in nature. At present, Canadian Natural Resources Ltd. (CNQ) is finishing one of its expansion phases at its Horizon Oil Sands project. Imperial Oil Ltd. (IMO) recently finished an expansion phase at its Kearl Oil Sands project. Suncor Energy Inc. (SU) is still building its big oil-sands mine, the Fort Hills project. (Teck Resources Ltd. (TCK.B) and Total E&P Canada Ltd. are co-owners. Suncor is the operator.) Suncor started building Fort Hills some time ago and it will come into production only in 2018, if the company hits its time line. It's a five-to-10-year build from start to finish, whereas in the United States, with the shale-oil plays, you can have new production on stream in six to nine months. Suncor's project is likely to be the last of its kind. Part of this is the geological reality and part of this is the economic reality.

Mark Thomson: Oil-sands mining needs about US$90 to US$100 per barrel of oil to get a return, whereas with the steam-assisted gravity technique (SAGD) it is in the vicinity of US$45 to US$60 per barrel. Cenovus Energy Inc. (CVE) has a SAGD project.

Longer term, if someone said oil could go to US$70 to US$80 per barrel and liked the long-term life of some of these Canadian assets, I would agree. These businesses have already spent the money on capital expenditure and the operating costs are low enough that they can generate capital. But our problem is that stocks like CNQ and Suncor are trading close to US$70 a barrel on a net-asset-value basis. We think that some of these stocks are now fully priced. The one exception to that are the SAGD operators, like Cenovus.

Canadian Natural
Resources Ltd.

Cenovus Energy Inc.

Suncor Energy Inc.

Nov. 7 close

$40.64

$18.78

$40.10

52-week high/low

$44.38-$21.27

$21.46-$12.74

$42.14-$27.32

Market cap

$45.2 billion

$15.7 billion

$67.5 billion

Total % return 1Y*

23.5

-9.8

4.5

Total % return 3Y*

10.0

-11.8

6.3

Total % return 5Y*

3.1

-8.0

6.0

*As of Nov. 7, 2016
Source: Morningstar

Daniel Bubis: Suncor recently reported excellent results. There's an opportunity on the energy-service side. If the oil price goes up toward US$60 per barrel, they'll be huge beneficiaries and the stocks are inexpensive. But you would not want to own these companies for the long term, as they're highly cyclical.

O'Brien: I'm a little more optimistic than Danny and Mark about the outlook for the Canadian energy sector. Oil is unlikely to be dramatically higher in the near term, but I do believe that it's trending in the right direction and that the stocks will continue to be among the better performers in the index over the longer haul.

Q: How will the federal government's carbon-pricing policy, under which all Canadian jurisdictions will have carbon pricing in place by 2018, affect the energy sector? What will also be telling is Ottawa's decision, expected by Dec. 19, on the Trans Mountain Expansion Project.

Daniel Bubis

O'Brien: These are two sides of the same coin. There's been a broad shift in Canadians' attitudes toward the environment. At the same time, the reality is that Canada is a resource-dependent economy and the energy industry is an enormously important part of the Canadian economy. There is a need for the new government to balance these two realities. The decision on Trans Mountain will tell you if the government is able to find that balance.

Bubis: Pipeline expansion is an important issue in Canada. The global commodity is rebalancing, but capital won't be put to work in Western Canada unless there is some takeaway capacity. If you really want jobs and economic growth, it's not about the oil price, but it's about the capital that it attracts. The carbon taxes have been gradually priced into the market. It's the cost of doing business. The question is how much Canada's carbon tax is versus the rest of the world? Oil is a global commodity. I doubt if they will have a carbon tax in Russia, China or the United States. However, I do, like Mike, think that the pipeline decision is the bigger issue. If you talk to the energy companies, the pipeline issue is what they are more concerned about.

Q: Having discussed the macro backdrop for energy, time to discuss your overall portfolios and the number of Canadian names in these portfolios. Mark is Canada only, but Danny and Mike can have foreign content. Let us start with energy. Please identify your principal energy names in this sector and discuss the issue of the services companies.

Thomson: Beutel Goodman Canadian Equity has 30 names. We have two main energy holdings: Cenovus, with a 5.5% weight, and Canadian Natural Resources, also with a 5.5% weight. We have a small weighting in Suncor. The stock did not stay down long enough for us to buy more. CNQ's stock, like that of Suncor, is getting fully priced. We think that Cenovus still has some good upside. These three companies have long-life assets, good cash flows and not much demand on capital. You are going to see good, sustainable dividends over time. They are real investment vehicles, while many of the other energy stocks are more of a trade.

Mark Thomson

Bubis: We have some 40 Canadian names in CI Canadian Investment. Our biggest names in energy are Suncor and CNQ. Another producer that we own is Vermilion Energy Inc. (VET). What's interesting about all three companies is that you had this big drop in the oil price and they didn't get impaired. A lot of their peers did. Suncor, CNQ and Vermilion used the downturn to get better. They have reduced their cost structures and shown good capital discipline. As a contrarian, I do own some energy-services companies, but these are unlikely to be long-term holdings. We have a position in Precision Drilling Corp. (PD) and a small position in a fracking company, Canyon Services Group Inc. (FRC). The whole industry has been decimated. Canyon has not been making money, but it has among the strongest balance sheets in this industry. You have to be careful, as I said, as the industry is highly cyclical.

O'Brien: Our Canadian holdings number in the low 40s. We have a tiny position in Precision Drilling. To Mark's point, the core energy holdings are the big, strong companies. Our largest three positions are Suncor, CNQ and Cenovus. The fourth largest energy position is a company that is transitioning from what used to be a small-cap to one of the more elite large-caps, and that is ARC Resources Ltd. (ARX). It is a well-run business. It is a business built to last and its management team is extremely high quality.

There is room, at this stage in the cycle, for smaller names. Two names that I own here are Whitecap Resources Inc. (WCP) and Tourmaline Oil Corp. (TOU).

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